BDO's Neil Fung-On says investment managers are failing to address the risks associated with the Alternative Investment Fund Manager’s directive.
In April 2009, the European Commission (EC) published its far-reaching proposals for a directive on Alternative Investment Fund Managers (AIFM). The stated aim was to “provide a clear and consistent framework for the regulation and supervision of managers of alternative investment funds in the EU”. Lack of harmonisation across the EU meant risks were not managed and discouraged the passporting of AIFs across the EU.
Following a series of draft reports from the EC and parliament, a final text should be agreed in May 2010 with implementation pencilled in for 2012.
The proposals are to directly regulate fund managers as they are responsible for decision-making and the relationship between investors and administration functions within funds.
This catch-all approach means, as initially proposed, it will impact upon the management and administration of most collective investment vehicles not presently covered by Ucits. This will include hedge funds, private equity – carried interest and co-investment schemes, real estate funds, infrastructure funds, commodity funds, closed investment funds, VCTs, Reits and even regulated non-Ucits funds. The cost of compliance for these entities is potentially significant and detrimental.
The directive seeks to control systematic risks, ensure appropriate investor protection and enforce appropriate transparency of funds; all considered to present a threat to the stability and integrity of EU financial markets.
However, with so much uncertainty surrounding the final directive, fund managers have found it hard to plan ahead. In a recent survey conducted by BDO, which asked investment managers to identify their top risks, only 3% of respondents cited the AIFM directive as a key risk for 2010.
While the benefits of a passporting scheme for AIFMs are clear, serious concerns have been raised by politicians, national regulators, trade bodies and others over the directive. Criticisms have focused on the potential quality of the legislation due to the speed of the directive, the implementation and ongoing costs which will have to be passed onto investors in the form of lower returns and the dilution of investment choice that a potential restriction of investment in non-EU AIFs will bring.
For a complex piece of legislation covering a range of investment firms with different business models, timescales for the directive are very tight, and this is seen as an impediment to the quality of the legislation. The tabling of nearly 1,700 amendments supports this belief.
The initial directive was published on 30 April 2009, five subsequent reports have been produced by the EC and parliament, and MEPs are scheduled to agree the final text in May this year, though this may have to move due to the large number of amendments. Think tank Open Europe pointed out that while the EC recommends a minimum eight weeks’ consultation, only six were given for the AIFM directive and these included the Christmas break.
The Bank of England’s Financial Markets Law Committee has said the draft directive would trigger “systemic failure and widespread market disruption” if made into law and if implemented in its current form, would be unworkable and would “create significant legal uncertainty”.
As drafted in April 2009, managers based outside the EU will be prohibited from marketing their funds in the EU unless they can meet strict fiscal and regulatory requirements. The impact report commissioned for the FSA stated this would result in 40% fewer hedge funds and 35% fewer private equity funds being available for EU investors. Choice and value for money would therefore be weakened.
The cost of compliance could result in managers delivering lower returns to investors as they pass these costs on. The impact study for the FSA indicated one-off costs across the EU of €3.2bn would be borne by the industry with hedge funds accounting for 44% and private equity 24%. Ongoing costs are estimated at €311m but another impact study by Open Europe puts the ongoing compliance costs just for hedge funds and private equity at three times this figure.
Perhaps the harshest statistic came from the European Parliament’s own impact study, which found the directive could reduce EU GDP growth by 0.2% annually.
Why are fund managers not addressing the risks associated with the directive?
I believe fund managers are not addressing the risks associated with the directive as the precise nature of those risks is still unclear. In addition to the initial directive and five subsequent papers, another layer of complexity was added with the move of the presidency from Sweden to Spain.
What do managers need to do now?
MEPs will be discussing the amendments again in mid-March so it is not too late for managers to express their concerns directly with their MEPs and through their trade bodies.
AIFMs should consider preparing for the directive by ensuring investors and other key stakeholders are aware of its impending implementation. Communicating what the key risks are and how they will be affected will be important. AIFMs should look at their risk management function and consider how appropriately it fits the directive, planning for costs of set up and ongoing compliance.
Due to the broad nature of the legislation, a number of fund types are covered but some key issues are more applicable to certain fund types. Hedge funds may need to consider restructuring the domicile of their funds, pushing investment strategies onshore, which could result in significant initial costs and large tax charges.
What is apparent is the directive in some form will be enacted and with qualified majority voting, national governments cannot veto it. Investment managers should keep a close eye on the draft changes and plan ahead, mapping their investor base, fund domiciles and current risk management procedures.
An effective strategy to plan for the directive can spell the difference between winners and losers, especially as 2010 will continue to present a challenge for investment managers.
Neil Fung-On is a financial services partner at accountancy firm BDO
